Cost Management Theory

COST MANAGEMENT THEORY

For CA Final

Some Areas in Cost Management syllabus which are vulnerable and can be asked

in the exams

Prepared on the basis of CA Institute’s Material for Cost Management (CA Final)

SK Bellary, Karnataka

PROLOGUE

This material has been prepared exclusively and absolutely from the point of view of the

exams. As a result, this material is strictly not recommended to students who are having

objective other than passing the exams with least effort.

As seen in the exams, the theoretical part though, may cover substantial marks, is usually

asked for not more than 5 marks per question. Keeping in view the pattern of theoretical

questions in exams, some of the topics which are very vulnerable of being asked are jotted

down in the enduring part of this material.

Chief efforts of students have to be directed towards the practical aspects of the syllabus, with

special attention to Marginal Costing, Standard Costing and Quantitative Techniques. Hence as

a time saver, this material can be referred to cover the theoretical part of the question paper

to be confronted in the exams. Remember, One cannot read and retain every other thing

found in the syllabus. One has to limit the coverage, but rationally, which has been attempted

here.

TOPICS COVERED 1. JUST-IN-TIME APPROACH............................................................................... 1 2. BACK FLUSHING .......................................................................................... 2 3. TARGET COSTING (TC) ................................................................................. 2 4. KAIZEN COSTING......................................................................................... 5 5. TOTAL QUALITY MANAGEMENT ......................................................................... 5 6. PRAISE SYSTEM......................................................................................... 7 7. VALUE CHAIN ANALYSIS................................................................................. 8 8. COMPETITIVE ADVANTAGE AND CUSTOMER VALUE: ................................................. 9 9. ASSESSMENT OF COMPETITIVE ADVANTAGE .........................................................10 10. STRATEGIC FRAMEWORK FOR VALUE CHAIN ANALYSIS ............................................10 11. VALUE CHAIN ANALYSIS VS. TRADITIONAL MANAGEMENT ACCOUNTING ........................11 12. BUDGETARY CONTROL SYSTEM ........................................................................12 13. TYPES OF BUDGETS .....................................................................................13 14. DISTINCTION BETWEEN FIXED AND FLEXIBLE BUDGET .............................................13 15. BUDGET RATIOS.........................................................................................14 16. ZERO BASED BUDGETING ..............................................................................14 17. PERFORMANCE BUDGETING ............................................................................15 18. BALANCE SCORECARD ..................................................................................15 19. DISADVANTAGES OF BALANCED SCORECARD ........................................................16 20. WHETHER BALANCED SCORECARD APPLICABLE TO EXTERNAL REPORTING?.....................17 21. BENCHMARKING .........................................................................................17 22. STANDARD COSTING VS. BUDGETARY CONTROL....................................................18 23. BENCHMARKING CODE OF CONDUCT..................................................................18 24. PRICING POLICIES – TYPES............................................................................19 25. THEORY OF PRICE .......................................................................................20 26. PRICING STRATEGIES...................................................................................20 27. PARETO ANALYSIS.......................................................................................21 28. MARGINAL COSTING VS. ABSORPTION COSTING ...................................................22 29. COST-VOLUME-PROFIT (CVP) ANALYSIS............................................................22 30. TRANSFER PRICING – MEANING AND METHODS ....................................................23 31. CRITICAL PATH ANALYSIS..............................................................................23 32. CPM VS. PERT............................................................................................24 33. RESOURCE SMOOTHING VS. RESOURCE LEVELING .................................................25 34. APPLICATIONS OF LEARNING CURVE..................................................................25

COST MANAGEMENT (CA FINAL) NOTES FOR EXAMS

SK, Bellary, Karnataka -1-

1. JUST-IN-TIME APPROACH

• MAJOR OBJECTIVES:

i. Producing only what is actually needed. ii. Elimination of wastes

• INVOLVES:

i. Ensuring receipt of materials on exact date and exact time. ii. Delivery directly to production floor. iii. Engineering staff to visit supplier to inspect their quality control check iv. Installing a simple system v. Shortening setup time vi. Reducing scrap costs vii. Reducing WIP inventory

a. Using “KANBAN CARD” system and b. Implementing “Work Cell” or “Machine Cell” Concept.

viii. Single Consolidated Monthly Payment to Supplier ix. Reducing Wastage in Time, Assets and Materials

• IMPACT OF JIT(ADVANTAGES):

i. Reduces Wastage in Time, Assets and Materials ii. Helps in Identifying Defective Parts in Production immediately. iii. Reduces Overheads and other costs pertaining to:

a. Material Handling b. Quality Inspection c. Interest d. Insurance e. Taxes f. Warehouses – Rent, Employee Cost, Equipments.

iv. Reduces Working Capital Level v. Reduces Inventory of all Types vi. Improves Quality of Product vii. Fastens Delivery Time viii. Reduces Customer Complaints ix. Improves Inventory Turnover Eg: Toyota Co. – improved to 70%

• PERFORMANCE MEASUREMENT OF TRADITONAL SYSTEM NOT APPLICABLE JIT APPROACH:

i. Machine Utilisation: -- Involving measurement of performance w.r.t Speed, Automation, Size.

Not of any use in JIT as JIT does not require to Pile up the inventory of finished goods.

ii. Piece Rate System: -- Avoid Piece Rate System in JIT as JIT will not reward or give incentive to

workers who pile up the inventory. Time Rate system is recommended. iii. Direct Labour Tracking:

-- Attendence of Workers, Time sheet, clocking Barcoded IDs, etc. Avoid DL Tracking as these are non-value added activities. This makes people work faster without giving importance to quality.



2. BACK FLUSHING

• FEATURES

i. No Data Entry is made in the Accounting system till production of product is complete.

ii. Entry of Total Quantity finished is only entered in the system at the end of the production.

iii. Using the data in the Bill of Materials (BoM), the info regarding the quantity of materials used in the production process is ascertained. (Hence called “Back

Flush Accounting”) iv. Adjustments to the Inventory of Materials is made from the data obtained in

(iii)

• PROBLEMS IN BACK FLUSHING OR BACK FLUSH ACCOUNTING :

i. Production Reporting – has to be very correct as it is the only input available to update Inventory. Any error will result in mayhem in the Inventory records.

ii. Scrap Reporting – has to tracked and recorded properly else may lead to misappropriation and errors.

iii. Lot Tracking – becomes impossible.

iv. Inventory Accuracy – cannot be justified always. Some elements of doubts are always lingering.

3. TARGET COSTING (TC)

• DEFINITION :

PERFORMANCE MEASUREMENT OF JIT

Customer Complaints

Customer Service

Quality Maintenance Cost

Inventory Turnover

Occurrences of Scrap

Setup Time Reduction

Generation of New Ideas



“A Structured Approach to determining the cost at which a proposed product with

specified functionality and quality must be produced, to generate a desired level

of profitability at its anticipated selling price.”

--- It is an important part of a comprehensive management process aimed at

helping an organization to survive in an increasingly competitive environment

--- It is a misnomer; it is not a product costing system but rather a management

technique aimed at reducing a product’s life cycle cost

--- Target Costing becomes useful or can be considered inevitable when

majority of product costs are locked in during the product design phase

• STEPS INVOLVED IN TARGET COSTING:

TOOLS SUPPORTING TARGET COSTING

Functional Analysis

Value Engineering (VE)

Value Analysis (VA) Concurrent Engineering

Set Target Selling Price based on Customer Expectation and Sales Forecasts.

Establish Profit Margin based on Long Term profit objective and projected volumes

Determining Target Cost per unit

Compare with the Current Cost of the product.

Establish Cost Reduction Targets for each component of the production activity using VA and VC



• VALUE ANALYSIS:

Study of Activities involved in producing the product to detect NON-VALUE-ADDED ACTIVITIES which can be eliminated or minimized to save costs, but without adversely affecting the functionality or quality of the product.

• VALUE ENGINEERING:

Searching for Opportunities to modify the design of each component or part of the product to reduce cost, but without reducing functionality or quality of the product.

• PROBLEMS WITH TARGET COSTING:

i. Lengthy Development Process

ii. Mandatory Cost Cutting result in reduced employee or worker morale due to finger pointing especially employees, making it burdensome to provide disproportionately large part of savings.

iii. Difficulty to reach consensus because of several minds representing no. of

dept.s

• IMPLEMENTING TARGET COSTING IN THE ORGANISATION:

i. Requires participation of several dept.s

ii. Requires motivation of management

iii. No Delay should occur in implementing target once designed else, it will lead to serious cost overruns in the design cost and ultimately results in abrupt termination of entire TC.

Create Project Document or Charter.

Obtain Management Sponsor

Obtain Budget for Implement TC

Assign a strong team manager to take ahead implementation process

Enroll full time participants and use project management tools (Microsoft Project)



4. KAIZEN COSTING

• A Japanese Term representing a number of cost reduction steps that can be used subsequent to issuing a new product design to the factory floor

• Steps involved are similar to Value Engineering Phase, But VE is more active in the initial phase of product development and relatively passive in the subsequent stages. Kaizen Costing is active in all stages of product development

• Cost Reduction through KC results in less impact vis-à-vis VE but are still worth the effort since competitive pressures are likely to force down the price of a product over time.

• Market Price continues to drop over time, which forces a company to use target and Kaizen Costing to reduce cost and retain its profit margin. However prices eventually drop to the point where profit margins are reduced, which forces the company to develop a new product with lower initial costs and for which Kaizen Costing can be used again to further reduce costs.

5. TOTAL QUALITY MANAGEMENT

• It is too often viewed as a technique whose usefulness is confined to manufacturing processes.

• TQM assumes potentially greater importance as a tool for improved efficiency in service areas

• W. Edward Deming and Joseph Juran were the original proponents of alternative versions of TQM. They are joined by Crosby and Feingbaum in the US in popularization of TQM.

• TQM seeks to increase customer satisfaction by finding the factors that are limiting current performance. The practice of TQM in a manufacturing environment has produced tangible improvements in efficiency and profitability as a result of small improvements.

SIX Cs of

TQM

COMMITMENT

CULTURE

CONTINUOUS IMPROVEMENT

CONTROL

CUSTOMER FOCUS

CO-OPERATION (TEI)



i. Commitment : Commitment for improving quality

ii. Culture : TQM aims at changing culture and attitude

iii. Continuous Improvement : TQM is a process (a continuous one) and not a programme.

iv. Co-operation : Total Employee Involvement (TEI)

v. Customer Focus : Perfect Service with zero defects, needs of the customer are the major driving thrust.

vi. Control : Control over the process and the organization.

• QUALITY CONTROL VS. QUALITY ASSURANCE VS. QUALITY MANAGEMENT

• OPERATIONALISING TQM:

Quality Control

• Relates to Past Events.

• Deals with Past Production Data

• Allows suitable action to be taken

Quality Assurance

• Relates to Present Events.

• Involves putting in place the systems to prevent any defects

Quality Management

• Relates to Future Events.

• Involves managing people

• Ensuring continuous process of improvement

How do we compare with other organization?

What does the customer expects from us

Who is the customer?

What are the customers decision making requirement ?

What problem areas do we perceive in the decision making process?

What can we gain from Benchmarking?

What does the customer think?



6. PRAISE SYSTEM

• Involves Identification of Improvement Opportunity and Quality Improvement Process.

Identification of Improvement Opportunity

Quality Improvement Process

New Strategies

Elimination of Deficiencies

Finding Solution

PRAISE System

Problem Identifcation:

• Areas of Customer Dissatisfaction

• Absence of Competitive Advantage

• Complacency regarding Present Arrangement

Ranking:

• On the basis of

o Perceived Importance

o Ease of Measurement

Analysis:

• Identify possible causes

• Avoid Premature Conclusion

• Potential Implication

• Quantification of Cause and Effect

Innovation:

• Creative Thinking

• Methods of Operationalising solution

Solution:

• Implementing Solution

• Taking Apt steps to bring required changes

Evaluation:

• Monitor effectiveness of actions



7. VALUE CHAIN ANALYSIS

• A Strategic Tool to measure the importance of the customer’s perceived value is known as the Value Chain Analysis.

• By enabling companies to determine the strategic advantages and disadvantages of their activities and value-creating processes in the market place, Value chain analysis becomes essential for assessing competitive advantage.

• The concept, tools and techniques of a value chain analysis apply to all those organization which produce and sell a product or provide a service.

• Porters Definition of Value Chain Analysis:

“Internal Process or activities that a company performs to design, produce,

market, deliver and support its product.”

• John Shank and V. Govindarajan’s Definition:

“The value chain for any firm is the value creating processes or activities all the

way from basic raw material sources from compound suppliers through to the

ultimate end-use product delivered into the final consumer’s hands”

Supplier’s Value Chain

Buyers Value Chain

Disposal/ Recycle Value Chain

Design

Research &

Developmt

.

Procurement

Technical Development

Human Resource Management

Firm Infrastrucure

Firm

Value Chain

Distribution Value Chain

Production

Marketing

Distribution

Service



8. COMPETITIVE ADVANTAGE AND CUSTOMER VALUE:

• Secret of Success = Supply what customer want to buy + Service Competition

• Firms’ Competitive Advantage = Value offered to customer – Cost of Creating Value

• Two Forms of Competitive Advantage:

SUPERIOR

Differential Advantage

Differential + Low Cost

Advantage

RELATIVE

DIFFERENTIAL

POSITION

INFERIOR

Stuck-in-the-middle Position

Low – Cost Advantage

INFERIOR

SUPERIOR

RELATIVE COST POSITION

Competitive Advantage

Differential Advantage:

• When customers perceive that a business units’ product offers high quality.

• This advantage makes them ready to pay premium price over the market average

Low Cost Advantage:

• When total costs incurred by the firm in producing and marketing products are less than Market Average.

• Can Maintain to the Average Market Price and earn more profit (or)

• Can Fix Price lower than the Market Average Price and still earn more revenue and thus profit



9. ASSESSMENT OF COMPETITIVE ADVANTAGE

10. STRATEGIC FRAMEWORK FOR VALUE CHAIN ANALYSIS

• VC Analysis requires strategic framework for

i. Organizing internal and external information

ii. Analyzing information

iii. Summarizing findings and recommendations

Internal Cost Analysis

Vertical Linkage Analysis

Objective

• Determining sources of Profitability

• Determine relative cost position

Objective

• Understand Relationship and Associated Costs among suppliers and customers

Internal

Differentiation Analysis

Objective

• Understand sources of Differentiation Advantage

Steps involved

• Identify the firms value creating process

• Determine portion of total cost of the product or services attributable to each value creating process

• Identify cost drivers for each process

• Identify Links between processes

• Evaluate Opportunity for achieving relative Cost Advantage

Steps involved

• Identify customers value creating process

• Evaluate differentiating strategies for enhancing customer value

• Determine best sustainable differentiation strategies

Steps involved

• Identify the industry’s value chain

• Assign Costs Revenues and Assets to value creating process Diagnose the cost Drivers for each value creating process



• Three Useful Strategic Framework

i. Industry Structure Analysis: - Five Factor model developed by Michael Porter, to evaluate potential attractiveness

a. Bargaining Power of Buyers

b. Bargaining Power of Suppliers

c. Threat of Substitute products or services

d. Threat of New Entrants

e. Intensity of Competition

ii. Core Competence Analysis: - Identified by following tests:

a. Can it be leveraged?

b. Does it enhance customer value?

c. Can it be imitated?

iii. Segmentation Analysis: - Industry is a collection of Different Market Segments. Grant’s Five Step analysis involves :

a. Identify a segmentation variables and categories

b. Construct a segmentation matrix

c. Analyze segmentation attractiveness

d. Identify key success factor for each segment

e. Analyze attractiveness of broad versus narrow segment scope

11. VALUE CHAIN ANALYSIS VS. TRADITIONAL MANAGEMENT

ACCOUNTING

Basis Traditional Management

Accounting Value Chain Analysis

FOCUS Internal Usage External Usage

PERSPECTIVE Value Added Entire set of linked activities from suppliers to end users

COST DRIVER

CONCEPT

Single Cost Driver applied at the overall firm level

Multiple Cost Driver eg.

Structured Drivers and

Exceptional Drivers. Unique cost Drivers for each value activity.

COST

CONTAINMENT

PHILOSOPHY “Across the Board” Cost Reduction

View it as a function of Cost Drivers



INSIGHT FOR

STRATEGIC

DECISIONS

Somewhat limited

Identify Cost Driver at the individual activity level For each activity, ask strategic question pertaining to

• Make vs. Buy • Forward/Backward

Integration

12. BUDGETARY CONTROL SYSTEM

• FEATURES:

i. Determining

� Objectives to be achieved

� Policy to be adopted to achieve the objectives

� Various activities to be carried on to achieve the objectives

ii. Drawing up plan or scheme of operation for each class of activity

iii. Laying Out system of Comparison of Actual Performance with relevant Budget and Finding cause for discrepancies.

iv. Ensuring Corrective Action to be taken where plan is not achieved

• COMPONENTS OF BUDGETARY CONTROL SYSTEM :

Components of BC System

Physical Budgets

• Sales Budget

• Production Budget

• Purchase Budget

• Manpower Budget

Cost Budgets:

• Manufacturing Cost Budget

• Selling Cost Budget

• Administrative Cost Budget

• R&D Cost Budget

Profit Budget:

• Sales Budget

• Profit and Loss Budget

Financial Budget:

• Cash Budget

• CAP-Ex Budget

• Budgeted Balance Sheet



13. TYPES OF BUDGETS

14. DISTINCTION BETWEEN FIXED AND FLEXIBLE BUDGET

Basis Fixed Budget Flexible Budget

CHANGE

No change in Actual Volume of Activity Achieved

Redrafted on the basis of Activity level achieved

ACTIVITY

LEVEL

Operated on one level of Activity and One set of Condition

Consists Various Budgets for different level of activities

VARIANCE

ANALYSIS

As all costs relate to only one activity level, Variance Analysis will be of no use

Variance Analysis provides useful information

COST AND

PRICE

As there can be significant difference in Budget and Actual Activity levels, Cost Ascertainment and Price Fixation will not provide correct picture

Facilitates correct ascertainment of Cost and fixation of Price, etc as Budgeting is made at different activity levels

COMPARISION Meaningless Comparison of Actuals with Budgeted Targets

Meaningful Basis of Comparison of Actual Performance

TYPES OF BUDGETS

Based on Capacity

Fixed Budget

Flexible Budget

Functional

� Purchases � Sales � Production � Cash � Plant Utilization

Master

� Consolidated Summary of Various Functional Budget

Based on Coverage

Based on Period

Long Term

� More than 1 year

Short Term

� Less than 1 year

Based on Conditions

Basic Budget

� Unaltered Overall Long Term Budget

Current Budget

� Short Term, related to current conditions only



15. BUDGET RATIOS

• CAPACITY RATIO = BUDGETED HOURS / MAX. CAPACITY

• STANDARD CAPACITY RATIO = HOURS WORKED / BUDGETED HOURS

• ACTIVITY RATIO = STD HOURS FOR ACTUAL PROD’N / STD. HOURS FOR BUDGETED PROD’N

• CALENDAR RATIO = ACTUAL WORKING DAYS / BUDGETED WORKING DAYS

• EFFICIENCY RATIO = STD. HOURS FOR ACTUAL PROD’N / ACTUAL HOURS WORKED

16. ZERO BASED BUDGETING

• It is an expenditure control device where, without reference to the past budget or achievements, each divisional head has to justify his entire fund requirement and prepare budget accordingly.

• David Hemminger – “A management tool which provides systematic method for

evaluating all operations and programmes, current or new, allows for budget

reductions and expansion in a rational manner.”

• The technique of ZBB suggests examining a programme or function or responsibility right from the scratch.

• Process of ZBB:

• Advantages of ZBB:

i. Provides a Systematic Approach for evaluation of different activities and rank them in order of preference for resource allocation.

ii. Ensures that critical functions for achievement of objective are being performed in best possible way.

Ranking them in the order of preference

Deciding the extent to which the technique of ZBB is to be applied

Determination of Set of Objectives

Identifying the areas where decisions are required to be taken

Developing Decision Packages

Preparation of Budget, i.e. Translating Decision Packages into Practicable Units and Allocating Financial Resources



iii. Provides opportunity to allocate resources based on the results of Cost – Benefit Analysis

iv. Identification and Elimination of Wasteful Expenditure

v. Close Linkage between Budget and Objectives of Company.

vi. Introduction and Implementation of System of Management by Objective.

• Limitations of ZBB:

i. Facing various operational problems while implementation.

ii. Time Consuming

iii. Costly

iv. Proper Training becomes inevitable requirement.

17. PERFORMANCE BUDGETING

• NIBM, Bombay defines PB as – “The process of analyzing, identifying, simplifying

and crystallizing specific performance objectives of a job to be achieved over a

period, within framework of organizational objectives, the purpose and objectives

of job. The technique is characterized by its specific directions towards the

business objective of organization”

• Considerations while drawing up Performance Report:

i. Significance

ii. Timeliness

iii. Accuracy

iv. Appropriateness

v. Discrimination

vi. Presentation

18. BALANCE SCORECARD

• An approach to the provision of information to the management to assist

strategic policy formulation and to ensure its achievement. It emphasizes the need to provide the user a set of information which addresses all relevant areas of performance in an objective unbiased fashion.

• The Central idea of the BS is that managers should develop the measures on which they manage the business from four different perspectives:



• Process of creating a Balanced Scorecard

19. DISADVANTAGES OF BALANCED SCORECARD

• The following are some of the reasons why Balanced Scorecard sometimes fail to provide for the desired results:

i. The use of non financial measures leads managers to think that they have a Balanced Scorecard already working for strategic purposes

ii. Senior Executives misguidedly delegate the responsibility of the Scorecard implementation to middle level managers.

FINANCIAL

PERSPECTIVE

Goals and Measures (How do we look to our

shareholders?)

INTERNAL BUSINESS

PERSPECTIVE

Goals and Measures (What should we excel at?)

INNOVATION AND LEARNING

PERSPECTIVE

Goals and Measures (Is it possible for us to

continuously improve and create value?)

CUSTOMER

PERSPECTIVE

Goals and Measures (How are we looked upon by

customers?)

VISION AND

STRATEGY

Identify Vision

Identify Strategies

Identify Critical Success Factors and Perspectives

Identify Measures

Evaluate Measures

Create Action Plan

Follow up and manage



iii. Companies try to copy measures and strategies used by the best companies rather than developing their own measures suited for the environment under which they function.

iv. There are times when Balanced Scorecards are thought to be meant for reporting purposes only. This notion does not allow a Business to use the Scorecard to manage Business in a new and more effective way.

20. WHETHER BALANCED SCORECARD APPLICABLE TO EXTERNAL

REPORTING?

Critics argue that if the Scorecard is indeed a relevant driver of long term performance, shouldn’t the information generated be of interest to the investment community? However, it has been noticed that the Scorecard does not translate easily to the investment community for the simple reason that it makes sense for the individual business units and different divisions with their own mission and strategy and hence these individual scorecards cannot be aggregated into an overall corporate scorecard.

However, in case the company somehow manages to overcome such a problem and indeed use its Scorecard for external reporting, it may end up passing sensitive information to its competitors which may end up being detrimental to the company in the long run. However, with changes in the thinking process of the investment community, such strategic reporting could well be accepted in the near future.

21. BENCHMARKING

• A technique for continuous improvement in performance

• Involves comparing performance w.r.t. product, services or activities against other benchmark organization either internally between firms or externally.

• Objective – “How products, etc can be improved and ensure that the

improvements are implemented”

• It is a performance measure that provides the driving force to establish high performance and means to accomplish these goals.

• Types of Benchmarking:

i. Competitive Benchmarking: - Comparing from inputs from competitor of same sector or industry

ii. Strategic Benchmarking: - Seek to improve performance by examining long

term strategies.

iii. Global Benchmarking: - Bridging of International Culture, Business Process,

and Trade Practices.

iv. Process Benchmarking: - Comparison of an Organization’s process with the

best practice organization.

v. Functional Benchmarking: - Organization look to benchmark with partners

drawn from different business sectors or areas of activity to find ways of improving similar function or work process.

vi. Internal Benchmarking: - Seeking comparison from within organization



vii. External Benchmarking: Seeking help from outside the organization that are known to be the best in the class. Two categories:

� Intra- Group Benchmarking

� Inter-Industry Benchmarking

22. STANDARD COSTING VS. BUDGETARY CONTROL

Basis Standard Costing Budgetary Control

SCOPE

More Intensive, related with control of expenses

More Exhaustive, concerned with the operation of Business Area as a whole

PROCESS

BASED ON… TECHNICAL ESTIMATES

PAST DATA adjusted to Future Trends

DEPENDENCE

For establishing Standard Costing, some form of Budgetary Control is important as there is a need to forecast output and prescribed set of working conditions

No need of Standard Costing for establishing Budgetary Control. It is independent.

AREA OF

APPLICABILITY

Standards are set mainly for Production and Production related Expenses

Budgets are compiled for all items of expenses permissible

COST VS.

FINANCIAL

ACCOUNTS

Standard Costing is the Projection of Cost Accounts

Budgetary Control is the projection of Financial Accounts

PURPOSE

Standards setup targets which are to be achieved by Actual Performance Standard Cost indicate what cost should be under given conditions

Budgets setup maximum limits of expenditure which should not be exceeded Budgets are anticipated costs meant to be used for forecasting

VARIANCES Variances are analyzed in detail as per their originating causes

Variances are not tracked through related accounts but are revealed in toto.

23. BENCHMARKING CODE OF CONDUCT

• Principles of Legality • Principles of Exchange • Principles of Confidentiality • Principles of Use



• Principles of First Party Contract • Principles of Third Party Contract • Principles of Preparation.

24. PRICING POLICIES – TYPES

• Cost-plus-Pricing :

� Estimate Cost of Production � Fix a Margin Profit and Fix Selling Price � This policy is against the General Rule “Price is determined by Demand and

Supply”

• Rate-of-Return Pricing :

� Margin = Desired Rate of Return on the Capital Employed or Invested � 3 Problems involved:

a. Computation of Capital Employed – very complicated and not uniform b. Items to be covered in the return or capital c. Rate of Return – which is a fair return?

• Variable Cost Pricing:

� Markup on the Variable Cost so as to cover Fixed Costs. � Overcomes following limitations of Total Cost Pricing

a. Arbitrary Allocation of Overheads b. Incorrect Estimation of Normal Output for Overhead Allocation

• Competitive Pricing:

� When a company sets its price mainly on the consideration of what its competitors are charging its pricing policy under such situations is called Competitive Pricing or Competition Oriented Pricing.

� Not necessarily same price as charged by Competitors � It can a percent higher or lower that the competitors price. � Types of Competitive Pricing:

a. Going Rate Pricing: Average Industry Price – Useful when difficult to

measure cost – Applicable in Homogenous Product

Markets b. Sealed Bid Pricing: Firms compete for jobs on the basis of Bids –

Objective is to get the contract bidding for – Firms

set price to the lowest possible extent – But not

below its marginal cost of production.

• Incremental Pricing:

� Involves comparison of Impact of Decisions on Revenues and Costs � If a pricing decision results in increase in overall revenue than in cost, it is

considered favorable � Considers change in cost rather than average cost � Overhead allocation are irrelevant � Complementary products demand considered � Opportunity cost to be covered by Incremental Revenue



Units

25. THEORY OF PRICE

• The Theory of Price propels the concept that Optimum Price is the price which yields the maximum profits.

• It is based on the rational assumption that every enterprises objective is to maximize profits.

• If a firm can sell unlimited number of units, TR (Total Revenue) line will be a straight line. i.e. TR=mx; where m – quantity sold; x – price per unit.

• But practically, additional units can be sold only by reducing price. This means total revenue increases, but the rate of increase declines with every additional unit.

• However Total Cost of Production will increase when no. of units produced increases.

TC

TR

z

• Z is the point where the difference between TR and TC is the maximum. It is the point of Optimum Volume. Any increase beyond this will result in negative growth in TR.

26. PRICING STRATEGIES

• MARKET ENTRY STRATEGIES:

i. SKIMMING PRICING:

� Suitable when demand is inelastic to price. � Maintain the price till product is established in the market � Initially very high price is fixed so as to skim the creamy consumers who

are not price sensitive. � Initial High Price covers the initial cost of production.

ii. PENETRATION PRICING:

� Low Price is fixed initially. � Suitable to penetrate the market initially � Penetrating Mass Market as quickly as possible. (Eg. Reliance Mobile)

Revenue and Cost



� Suitable when demand in price elastic, savings on Large scale production, significant threat of competition.

• PRICE DISCOUNTS AND DIFFERENTIAL:

i. Distributor Discounts: Discount based on buyers position in the supply chain.

ii. Quantity Discounts: Discount based on quantity purchased

iii. Cash Discounts: Discount based on promptness of payment

iv. Time Differential: Different prices charged for different times (Eg. Off season sale)

• PRICE DISCRIMINATION:

i. On the basis of Customers

ii. On the basis of Product Version

iii. On the Basis of Time

iv. On the Basis of Place

• GEOGRAPHIC PRICING STRATEGIC:

i. Whether buyer pays all the freight expense or the seller bears the entire cost or the seller and buyer share this expense.

27. PARETO ANALYSIS

• Vilfredo Pareto, a nineteenth century Italian Economist proposed the Pareto Analysis.

• Pareto Analysis is also known as “80:20” rule.

• It provides mechanism to control and direct effort by fact, not by emotions.

• Helps to clearly establish top priorities and to identify both profitable and unprofitable targets.

• Application of Pareto Analysis:

� Pricing of Products: It is usually found that 80% of revenue comes from 20% of the range of products. And 20% of revenue comes from 80% of the range. Top Management can take part in the pricing the product following under 80% revenue and delegate Mid and Low level management, the pricing responsibility of remaining products

� Customer Profitability: 80% of revenue comes from 20% of the Customers. By using Pareto Analysis, more concentration and better servicing can be adopted towards cream of the customers.

� Stock Control: 80% of the cost of inventory will be covered by 20% of the inventory size, being high value, low volume items. And remaining 80% of the inventory usually covers 20% of the Total Cost of the Inventory. In such cases, better inventory management can be extended towards such high value items.

� Application in Activity Based Costing: 20% of the Organization’s Cost Drivers drive 80% of the Total Cost. Hence such Cost Drivers can be better concentrated.



� Quality Control: Out of the total causes for limitations in quality, nearly 20% are the cause for approximately 80% of the problems arising in the quality.

28. MARGINAL COSTING VS. ABSORPTION COSTING

Basis Marginal Costing Absorption Costing

INVENTORY

VALUATION

Only Variable Cost is considered for Product Costing and Inventory Valuation

Both Variable cost and Fixed Cost is considered in Inventory Valuation

FIXED COST Fixed Costs are considered as Period Cost

Fixed Costs are charged to Cost of Production.

PROFITABILITY Profitability judged by PV Ratio Profitability judged by Apportionment of Costs

ROLE OF COST

DATA Cost Data highlights Contribution

Cost Data highlights Profit. Revenue – Total Cost.

DIFFERENCE IN

STOCK

Difference in the magnitude of Opening Stock and Closing Stock does not affect the unit cost of production

Difference affects the unit cost of production because of the impact of related Fixed Cost

29. COST-VOLUME-PROFIT (CVP) ANALYSIS

• Profit per unit depends upon the Selling Price and Cost of Sales

• Total Profit depends on the sale volume, which in turn depends inter-alia on Selling Price and cost of sales. By and large, cost also depends on the volume of the production.

• Thus a close relationship exists between cost, volume and profit.

• Analysis of this relationship opens up an interesting and useful field for the Management Accountant.

• CVP Analysis may be applied for Profit planning, cost control and Decision Making.

• Purpose of CVP Analysis: i. to forecast profit fairly and accurately ii. to setup flexi budgets iii. to evaluate performance for control iv. to ascertain the effects of cost of change in the volume for market expansion. v. to formulate price policies vi. to know the amount of overhead cost that could be charged to production.



30. TRANSFER PRICING – MEANING AND METHODS

• Transfer price is the price which one unit of an organization charges for a product or service supplier to another sub-unit of the same organization. The price charged for the transfer of goods of one division to another division is the cost to receiving division and income to the supplying division. It means that the transfer price fixed will affect the profitability of both divisions.

• METHODS OF TRANSFER PRICING:

i. PRICING AT COST:

� Actual Manufacturing Cost: Simplest, useful where responsibility of profit

performance is centralized.

� Standard Cost: Variances, if any, are absorbed by the supplying

units. It can also be transferred to user unit too.

Results inventory being carried at standard cost.

� Full Cost: Cost of Prod’n, Selling and Dist’n Expenses, Admin,

R&D, etc. No profit is allowed to be made but can

only recover the full cost.

� Full Cost + Mark up: Markup added to full cost is either expressed as a

percent of full cost or of capital employed.

ii. PRICING AT MARKET PRICE:

� In a competitive market goods/services cannot be transferred to its users at a higher price. Such competitive market provides incentives to efficient production.

� Limitations

a. Difficulty in obtaining fair and just market price

b. Difficulty in obtaining elements of S & D expenses.

iii. BARGAINED OR NEGOTIATED PRICES:

� A Refinement of market price method.

� Each unit is considered as an independent unit and such units decide the transfer price by negotiations or bargaining.

� Each Divisional manager has full freedom to purchase their requirement from outside if the prices quoted by their sister unit are not acceptable to them.

31. CRITICAL PATH ANALYSIS

• Critical Path Analysis, which includes PERT/CPM, is a network technique/models. It helps the Project Manager in Planning, Scheduling and Controlling and estimate requirement of resources.

• Work Methodology of PERT/CPM involves:



• Advantages of Critical Path Analysis:

� Provides comprehensive view of the project.

� Offers economical and effective system of control based on Management by exception

� Constant review and reformulation of the network

• Activity: An Activity is any portion of a project which consumes time or resources and has a definable beginning and end.

• Event: The beginning and ending point of an activity.

• Purpose of CPA(Two fold purpose):

� Finding the Critical Path

� Finding Floats associated with each activity.

32. CPM VS. PERT

• CPM is incapable of handling uncertainty in timing which is a rule rather than exception for innovational project. PERT is more relevant for handling such projects which have a great deal of uncertainty associated with the activity durations. To take this uncertainty into account, three types of time estimates are generally obtained.

• These are:

� Optimistic Time Estimate (to)

� Pessimistic Time Estimate (tp)

� Most Likely Time Estimate (te)

• Expected Time for each activity is calculated using these three estimates on the basis of beta distribution. Following formula reveals the Expected Time for completion of each activity.

Monitor-Evaluate-Control the progress of project by replanning, re-scheduling, and re-assignment of resources

Determine the sequence of specific activities and their interdependence

Analyze and Breakdown Project in terms of specific activities.

Assign Estimates of Time and Cost for each activity

Identify the Longest or Critical Path



6

• Probability of completing a project with Expected Time is at 50% as it lies in the middle of the Normal Distribution Curve. Probability can be found out using Normal Distribution Table, but for which we require Z value.

• Z= Td -Tcp / S.D

where Td – refers to desired time to complete project

Tcp – refers to Duration of the Critical Path

S.D – Standard Deviation of the Earliest Finish Time.

33. RESOURCE SMOOTHING VS. RESOURCE LEVELING

• Resource Smoothing is a network technique used for smoothening peak resource requirement during different periods of the project network. Under this technique, the total project duration is maintained at the minimum level. The non-critical activities having floats are rescheduled or shifted so that a uniform demand on the resources is achieved.

• Resource Leveling is also a network technique which is used for reducing the requirement for particular resource due to its paucity. The process of resource leveling utilizes the large floats available on non-critical activities of the project and thus cuts down the demand on the resource. In resource leveling, the maximum demand of a resource should not exceed the available limit at any point of time.

• Constraint in Resource Smoothing is on the project duration time. While in Resource Leveling, Constraint is on the limit of the resource availability.

34. APPLICATIONS OF LEARNING CURVE

• Helps to analyze Cost-Volume-Profit Relationship during familiarization phase

• Helps in budgeting and profit planning

• Helps in pricing

• Helps design engineers in making decision based upon expected rates of improvement

• Helps to Government in negotiations about the contracts.

• Helps in setting standards in learning phase.

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Cost Management Theory

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